Posted on 01 November 2009 with no comments from readers

Short positions are what you need in a falling stock market. There is nothing else in the equity universe that will perform inversely to the market, and that is what you have to do to profit from a stock market correction or crash.

Technical indicators have been stacking up to the ceiling to confirm an end to the recent rally as the Dow Jones topped the psychologically important 10,000 barrier. Fundamental indicators show that markets should never have gotten this high, and are good reason to think governments will not be interested in preventing a correction now.

Short ETF heaven

So cast an eye over the three top performing exchange traded funds last Friday: EDZ Emerging Markets Bear3X +13.33%; FAZ Financial Bear3XNew +12.51%; Powershares DB Crude DTO +11.16%.

Of course you need to be pretty brave to invest in these ETFs considering their 12-month performance: EDZ -89.6%; FAZ -94.1%; and DTO is down 73.3% from its March high. And these figures are after the recovery last week.

But that is also the beauty of these short ETFs. Imagine that the stock market had just crashed. Would you not look carefully among the wreckage for good companies with unreasonably low valuations? And would you not want to buy them just as the market seemed to be almost sure to recover sharply?

That is what you are getting with these ETFs, and there is quite a universe of short ETFs to choose from. Sure there might be third party risk on some of these, so diversification is ever the wise policy if you choose to invest in this asset sub-class.

Normally I must admit I would shy away from leveraged funds. They do have the unfortunate quality of magnifying losses as well as boosting upside potential. They do not always perform their market tracking function very well. And if you stay in them for long the fee structure works against a patient investor, so they are not for buy and hold.

Falling market

But for capturing the profit potential of a market reversal, especially what should be a big one then short ETFs seem ideally placed.

It would hardly be surprising if the biggest stock market rally in history which is where we are now coming from is not followed by the biggest correction. Heightened volatility in financial markets is one of the nasty side-effects of the massive government interventions that we have witnessed over the past year.

It is a devil of course if you get it wrong, so do not put all your eggs in this basket. But anybody long on stocks ought to consider this. Bond funds will also do well and the US dollar, otherwise all other asset classes including gold will come down with global stock markets in a big sell off, so consider hedging them too.